Five Key Business Valuation Considerations

What are the main elements that underpin a business valuation
November 4, 2022

1. Cash is King. At root, almost every business valuation is based on an estimate of the amount of cash that an investor in this company would be able to enjoy in the future. Essentially this is the same in respect of every investment-if you invest in a bond or in real estate, the value of such an investment relates to the interest rate on the bond or the rents payable from the building and the payment at the end of the investment, i.e. the repayment of the bond or the sale of the real estate (as the case may be).The same is the applicable in the case of an investment in a closely held company.

2. How risky is the company? The risk reflects an assessment of how likely an investor will be able to enjoy the future estimated future cash flows of the company. The lower the risk, the higher the value and vice versa. All other things being equal, an investor would pay more for a well-established, stable company with estimated cash flows of $500,000 than the investor would pay for an estimated cash flow of $500,000 from a startup company with no proven business model.

3. The Valuation Date. Every valuation requires the establishment of a valuation date. This draws a line in the sand stating that only information that is known or reasonably foreseeable as of that date is to be taken into account in the valuation exercise. In many cases, a valuation is carried out after the valuation date but events occurring after that date are not taken into account in the establishment of the value.

4. How Low Can You Go? In some cases the most appropriate way to value a business is to subtract what it owes from what it owns resulting in an asset value for the company. Essentially this approach assumes that the company ceases business, sells off its assets and pays its debts with the net amount representing its value. It’s appropriate to use this method when the value derived from the cash flow methodologies produce a value lower than its net assets - in other words, this is often the minimum value for a business.

5. Minority Report. In many cases the valuation relates to less than 50% of a company. An investor purchasing such an interest would not pay a pro rata percentage of the total value of the company. In addition to the general risks of an investment in the company, the investor would be taking on the risk that the controlling shareholder would abuse their position to the detriment of the minority shareholders and the additional risk that it would be difficult to resell the interest since the market for such an interest is very limited. As a result it is common to see discounts for lack of control and lack of marketability applied to non-controlling interests which, when combined in some cases can reach as high as 50% of the pro rata value.